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Don't follow the 'smart' money to Qantas

Nathan Bell

According to The Australian Financial Review, former Qantas finance chief Peter Gregg and Mark Carnegie—backed by a coalition that includes former Qantas chief Geoff Dixon, John Singleton and Lindsay Fox—are agitating for change, including an overthrow of current chief executive Alan Joyce.

Gregg and Carnegie have been in discussions with union groups and investors, allegedly pushing for a sale of the Qantas Frequent Flyer business, a partial float of Jetstar and a deeper push into Asia.

The article suggests that a full takeover of Qantas is not on the cards but that the group might take a stake in the airline if they think they can wrangle control.

It's a long-held view that following the smart money is a great investment strategy. And these people are both smart and experienced. But this is one case where following the smart money may be foolish.

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Had you followed Gregg, Carnegie and Dixon last time they made a pitch for Qantas—all were involved in the failed $5.60 private equity bid in 2006—you'd have lost almost 80 per cent of your money over the ensuing six years, assuming Qantas didn't enter administration.

Agitating for change makes more sense this time around.

If the plan is to break up the Qantas group and profit from a rerating of the good bits—principally its loyalty program and freight business—why not do it when the stock is trading at an almost 50 per cent discount to net tangible assets (NTA) rather than multiples thereof in 2006?

And there is a precedent. The separation of Aeroplan, Air Canada's frequent flyer program, from its parent was a success. Many other airlines are considering following suit.

But even at a huge discount to NTA, we're not convinced.

Famed author Samuel Johnson once said, "a horse that can count to ten is a remarkable horse, not a remarkable mathematician". One might argue that Qantas is a remarkable airline; no one could argue it's a remarkable business. In fact, it's terrible.

If Gregg, Carnegie et al obtain control, it might not make much difference. Airlines tend to struggle to earn decent returns on capital no matter who or what is running them.

Airlines are a high fixed-cost business. Success is extremely dependent on high capacity utilisation. That in itself isn't a bad thing—good toll roads mint money with similar characteristics.

Crucially though, customers tend not to differentiate between airlines on anything other than price. With lots of choice, pricing is cut-throat. Toll roads don't have that sort of competition.

All an airline's profit comes from is getting bums on the last few available seats at a reasonable price. Combining that with a competitive market and a lack of pricing power isn't a recipe for success.

Capital intensity is also a huge handicap. If an airline doesn't spend a few billion dollars on efficient new planes like the Dreamliner, the competition eats your lunch on fuel costs.

So the whole industry spends heavily on new planes, locking in sub-par returns on capital in the process. That's why so few airlines have been able to eke out even a reasonable return on capital.

Every other participant in the travel chain has the better of the airlines, from customers to airport owners, from aircraft manufacturers to heavily unionised staff.

There is one thing this industry does have that most lack—glamour.

Richard Branson, Warren Buffett and Sanjay Agarwal, owner of an Indian brewing monopoly that started Kingfisher Airlines, were all seduced by the smell of avgas and soaring metal. None fared well.

A poor business like this one tends to get the better of even brilliant minds. That's why following the smart money strategy is unlikely to work this time.

If it were announced tomorrow that Qantas was liquidating and returning all excess capital to shareholders, at the current price it would be worth a closer look.

But the chances of that are about the same as finding an old bar fridge on Mars, plugged in and stocked with Coopers.

This business is almost certainly locked into a cycle of investing large wads of shareholder capital at sub-par rates of return. It deserves every bit of its current large discount to NTA. AVOID.